How to protect your retirement portfolio gains

With various stock market indexes hitting record highs, retirees and those saving for retirement need to take steps to protect their hard- or, perhaps in the case of some, their luckily-earned gains.

But which tools and techniques make the most sense?

Well, for folks still saving and investing for their retirement — assuming you have designs on maintaining your positions until retirement and assuming you have access to a full range of investment options, experts say you should consider the following:

Think before you act

The first thing for retirees and pre-retires to understand is this: By attempting to protect a portfolio’s current gains, you could be making decisions that prevent the portfolio from further gains, said Steve Donahoe, a senior portfolio manager at CLS Investments and board member of the CFA Society of Nebraska. “It is important to understand the fundamentals of the market and how they play into the fact that just because the market is setting new highs does not necessarily mean it is going to correct. Valuations matter at least as much as index price levels in understanding the potential for further gains,” he said.

In looking at the history of the market, Donahoe said positive returns happen more frequently than negative returns. “Investing in the market is not a coin flip, but the edge really does go to the investor,” he said. “For the majority of investors it is important to stick with the investment plan they have in place and their balanced portfolios in order to ultimately reach their goals despite the potential for some set back in the stock markets.”

Others share this point of view. “Protecting gains is a common thought among investors who have seen assets appreciate and do not want to ‘give back’ those gains during a subsequent downturn in the market,” said Bruce Fernandez of InvestingByNumbers. “Putting aside for a moment the virtues of being a patient, long-term investor willing to accept the natural short-term ups and downs for the benefit of capturing a secular bullish market, there are several ways to ‘protect gains.’”

The simple tactics

The first of these tactics? Sell everything outright. “Selling the asset removes any downside risk, however it can subject the seller to capital gains tax,” said Fernandez. “For those paying estimated taxes, sales early in the year can result in an even higher upfront tax bill.”

Steve Smith, a portfolio manager at Noesis Capital Management, suggests that retirees who don’t have at two years of liquid assets at their disposal consider taking some gains now. “The cash gives you certainty and peace-of-mind during volatile periods, and retirees generally have a lower risk threshold,” said Smith, who noted that individual bond issues maturing over the next three years would be counted as liquid assets.

And, for the record, Smith said now would be a good time — given that Federal Reserve will at some point reduce its stimulus policy — to take gains. “While the Fed is a long way from raising the Fed Funds rate, they are no less draining liquidity from the system once they begin to wind down QE,” he said. “If the market forces this action upon them, the wind down will likely happen fairly quickly. Given that, I think it makes sense to take some gains now while also managing the tax liability by not taking it all in one year.”

Fernandez said another option would be to consider put options. “Put options allow the investor to specify the lowest price acceptable price (strike price) should the price decline,” said Fernandez. “Options are not available in all situations and the protection comes at a price. The closer the strike price is to the current market, the more the option will cost.”

Using options also requires a margin account. Taxes still need to be paid on the sale, though paying the tax will be better than giving back the gains when a significant price decline occurs, said Fernandez.

Another relatively easy way to protect your portfolio would be to use a stop-loss order. A stop-loss is an advanced order to sell a stock that is triggered when the market price of the stock reaches the specified, said Fernandez. A market order, he said, instructs the sale of stock “at the market” or the current price. A stop-loss order instructs the sale of stock if the market price hits the specified price. “It is important to remember that unlike a put option that insures execution takes place at the option strike price, a stop loss order does not guarantee execution will take place at the specified price,” Fernandez said. “Stop-loss orders become market orders once the trigger is reached. For instance, if the stop-loss is entered at a price of $35 and the market price falls through that price, the price received will be whatever the market is, be that $34.75 or $15.75. Stop loss orders are not an effective strategy to protect gains in a fast market that gaps down.”

Even worse is this: “If a technology glitch sends the price crashing, an investor might get executed at an extremely low price only to have the stock bounce back shortly thereafter,” said Fernandez.

Option collars

One of the most common and perhaps cheapest of the sophisticated tactics would be option collars. With option collars you would sell a call and use the proceeds to offset the price of a put. Higher correlations can be used to determine a proxy index for the retiree’s holdings in a liquid ETF . Assuming you know your retirement date, the collar can coincide with retirement.

Among the positives associated with this tactic, the returns are locked until the collar expires, and will vary only within the ranges set up by the collar. Plus, it not very capital intensive, and some can be costless.

No tactic is without its share of negatives, and this one is no different. With option collars, your portfolio will not benefit from continued market upside. And, if using the proxy method, there will be variance between portfolio and the underlying (basis risk). And, in a taxable account, you’re likely to have some short-term tax issues.

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